Equity Market Structure in 2016 and for the Future

Chair Mary Jo White

Thank you, Jim [Toes], for that kind introduction. I am honored to join you again for your annual market structure conference.

The American equity markets are the strongest in the world, and one of the Commission’s most important responsibilities is to work every day to maintain their fairness, orderliness, and efficiency. Optimizing market structure is a continuous process, one that requires the Commission to act with both care and intensity, strictly guided by what is best for investors and capital formation for public companies.

I emphasized this guiding principle when I last joined you in 2013,[1] and in 2014 when I laid out a program for enhancing equity market structure.[2] Fulfilling our responsibility to investors and issuers, of course, demands that the Commission act quickly to address issues that are demonstrably undermining the interests of investors and issuers. But it also requires the Commission to carefully consider changes to market structure where the impact on those interests is far less clear and the data to support competing perspectives is lacking or conflicting.

Where improvements to equity market structure are clearly called for, the Commission has acted. The operational integrity of our markets – my top priority – has been significantly enhanced by a number of measures. The staff is gathering and analyzing more market data than ever before to inform policymaking, and the consolidated audit trail is becoming reality. And we have detailed proposals out for comment that will give investors more transparency into how the off-exchange markets operate and broker-dealers handle their orders.

At the same time, the Commission has undertaken a deliberate, data-driven process to assess – and, as appropriate, begun to implement – more fundamental changes to equity market structure. This process requires great care. The American equity markets today continue to serve well the interests of retail and institutional investors, delivering better executions at lower costs than ever before. Broad changes to this market structure – especially those executed precipitously or without adequate data – can have serious unintended consequences for investors and issuers as their impact is fully realized, sometimes years down the road.

This two-pronged approach recognizes that market structure can never be perfect and, correspondingly, that the Commission’s work is never – and should never – be done.[3] Market structure is continually evolving as technology and competition spur innovation. That fluidity means that the Commission’s review must be both comprehensive and nimble, constantly testing existing assumptions, regulations, and market practices, while remaining poised to act quickly on issues that immediate attention can address.

Today, I want to report on some of our progress on both our targeted enhancements to tackle such issues, and our consideration of more fundamental market structure questions. While the Commission has been active in a number of areas, I will focus today on operational integrity, market transparency, and algorithmic trading.

In assessing these areas and others, we have been fortunate to have the assistance of our relatively new Equity Market Structure Advisory Committee, or EMSAC. Especially in addressing some of the more complex issues in market structure today, the EMSAC, which brings deep expertise and a wide range of perspectives, provides a public forum for valuable and timely discussions, both within the Committee itself and as a result of its efforts to reach out to a wide range of others with expertise on key issues.

Strengthening Operational Integrity and Market Stability

Let me begin where I always do, with operational integrity and market stability. Since I arrived at the Commission, enhancing the reliability and resilience of our markets has been my top priority. Weaknesses or disruptions in operations can destabilize markets and, in some cases, lead to extreme price volatility and the loss of investor confidence. The Commission’s work here continues – we can never be complacent – but I am very pleased with the steps we have taken to strengthen the market systems on which investors depend every day.

Regulation SCI

Central to this effort has been Regulation SCI, which the Commission adopted at the end of 2014.[4] While no measure can eliminate technology disruptions altogether, Regulation SCI is designed to reduce the occurrence of systems issues and to improve resilience and communication when systems problems do occur. It imposes requirements on key market participants – the exchanges, high‑volume alternative trading systems (ATSs), clearing agencies, the securities information processors (SIPs), the Financial Industry Regulatory Authority (FINRA), and the Municipal Securities Rulemaking Board (MSRB).

These “SCI entities” were required to start complying with most of the requirements of Regulation SCI last November.[5] In the first instance, this means maintaining comprehensive policies and procedures to ensure the capacity, integrity, resiliency, availability, and security of key automated systems. It also means: taking appropriate corrective action when systems issues happen; reporting systems problems and changes directly to the Commission and market participants; and conducting periodic reviews and testing of automated systems.

Approaching the first full year of the regulation’s operation, our examiners have been reviewing compliance with Regulation SCI. It is apparent from these examinations that many market participants have devoted significant resources to compliance, and there has been good progress in implementation. But a few areas for additional attention have emerged. For example, it is clear that processes for patching and updating systems deserve close attention – human errors in these routine tasks can create much more significant issues. Another example is diversifying primary and backup systems – in seeking to fulfill their recovery obligations under Regulation SCI, market participants should focus on not just the geographic locations of those systems, but also consider their reliance on different electrical, telecommunications, and other infrastructure support. Our staff is continuing to work with market participants in these areas and others to help ensure that the goals of Regulation SCI are achieved.

Improvements to Critical Market Infrastructure

Regulation SCI has been complemented by a number of initiatives by the exchanges and FINRA to enhance the operational integrity of critical market infrastructure like the SIPs and the open/close process. At my direction, following the Nasdaq SIP outage in 2013 and NYSE’s trading outage in 2015, SEC staff worked with the exchanges and FINRA to correct the defects that caused these incidents, as well as to identify and address other potential single points of failure. These cooperative efforts were expanded after the unusual volatility of August 24, 2015, and there has been significant progress.

First, the resilience of the SIPs is considerably improved. There are now enhanced disaster recovery sites and systems to establish a “hot/warm” backup process, which provides for a failover from the primary site to the backup site in ten minutes or less.[6]

Second, as of June, the equity listing exchanges now have mutual backup arrangements for their closing auctions, which will address situations when a disruption might prevent the execution of a closing auction on the primary listing exchange.[7]

And third, the process for opening auctions, especially in volatile markets, has been and continues to be improved.[8]

Enhancements to Volatility Moderators

Amidst these and other improvements,[9] reminders persist about the continued importance of the volatility moderators implemented after the “Flash Crash,” especially the “limit-up/limit-down” plan designed to reduce extraordinary volatility in individual securities. The exchanges and FINRA have already implemented basic enhancements to limit-up/limit-down in the wake of the events of August 24, 2015,[10] and I have asked them to address additional issues that emerged during that event.

Further Strengthening Market Operations

One such issue is the application of the mechanism to exchange-traded products (ETPs), where we have a broader program underway to help ensure that these increasingly popular products operate robustly in a variety of market conditions. We saw during the Flash Crash and on August 24 that ETPs can be disproportionately affected when markets become disorderly. Orderly trading in an ETP requires a smoothly functioning market for the ETP’s holdings so that market makers and authorized participants can reliably value the ETP’s portfolio. If the underlying market becomes disorderly, or if market makers and authorized participants step away from trading, the arbitrage mechanism can be disrupted and an ETP can trade at prices substantially away from its implied value.

Commission staff, as well as the exchanges and FINRA, are assessing the special characteristics of ETP trading in determining whether particular changes should be made to the limit-up/limit-down mechanism to reflect the sensitivity of ETPs to disorderly market activity.[11] In addition, I have directed the staff’s ETP Working Group to identify and analyze a broad range of issues relating to the structure, trading, and use of ETPs. The Working Group is considering, among other things: what portfolio characteristics and market structures support effective arbitrage; the roles and practices of market makers and authorized participants; and the effects of the ongoing exchange pilot programs to incentivize trading in less‑liquid ETPs.

Enhancing Market Transparency for Investors and Regulators

Transparency, like robust technology controls, is central to strong and efficient markets. And it is at the heart of their fairness. As the markets have changed over the last few decades, the informational needs of investors, other market participants, and regulators have changed as well. We have therefore devoted considerable effort to addressing the evolving gaps in transparency created by dynamic markets, including those in the operation of trading venues and how brokers handle orders. I have asked the exchanges and FINRA to do the same, and they have done so – from better describing how their order types work[12] to providing more information about data feed latency and usage.[13]

Transparency in Trading Venues

The Commission’s regulations for ATSs have remained largely untouched since 1998, when they were first adopted. Changes are due. As I have remarked before,[14] while ATSs now attract very significant trading volume – today, more than 15 percent of the volume of NMS stocks – they still generally provide very little information to the public about their operations.

Last November, the Commission proposed new rules to require NMS stock ATSs to make detailed public disclosures about their operations and the activities of their operators and affiliates.[15] These disclosures would include information about trading by the operator and affiliates on the platform, the types of orders and market data used on the platform, and the platform’s execution and priority procedures. It would also enhance the Commission’s oversight of ATSs by enabling the Commission to review changes to their operation and intervene if necessary. The comments on the proposal suggesting some adjustments have been very thoughtful, and I expect a staff recommendation for revision of Regulation ATS to be ready for Commission consideration in the coming months.

An important complement to this initiative is greater transparency in off-exchange trading. With volume of ATSs and other off‑exchange trading steadily above 30 percent, and the diversity of those venues growing, a significant gap in transparency had resulted – the public had no way to tell which venues were executing the off‑exchange trades.[16] I am pleased that FINRA has addressed this gap by providing enhanced disclosures on its website about these trades.[17]

Transparency in Order Handling

Another substantial transparency concern in the current market structure relates to the order routing practices of brokers, including the ability of large institutional customers to monitor those practices. Indeed, broker-dealers today are required to disclose little about their institutional order routing practices. With the large number of exchanges and other venues that trade NMS stocks, all investors should know more about how their brokers negotiate this dispersed landscape. This summer, the Commission published a proposal to require broker-dealers to provide greater disclosure about their order routing practices, including individualized disclosures for each investor.[18] The comment period on this proposal ends in about two weeks, and I look forward to reviewing the public input as we consider final rules.

The Consolidated Audit Trail

The transparency initiatives I have just outlined, as well as those undertaken by the exchanges and FINRA, address the availability of information to the public. As markets grow larger and more complex, regulators must also continue to have efficient access to the data we need for oversight – a principal goal of the consolidated audit trail, or CAT, which will enable regulators to accurately track securities activity throughout the U.S. markets.[19] The Commission published the CAT plan developed by the exchanges and FINRA this past April,[20] and we have received a number of detailed comments that the staff has been closely reviewing. There is no higher market structure priority for me than to ensure Commission consideration of a final CAT plan before the end of the year.

One of the major issues raised in comments has been the need for robust controls to protect sensitive personal information and proprietary data from cybersecurity threats. I share this priority, especially given the breadth of data that will be collected by the CAT. The Commission is carefully assessing the security requirements of the CAT plan and evaluating comments on optimal approaches to address data security concerns. The Commission, of course, must ensure that it has strong measures in place to protect the sensitive, non-public information it handles, and I am strongly committed to implementing such measures in conducting our regulatory oversight responsibilities using CAT data.

Addressing Fairness and Efficiency in Algorithmic Trading

The last category of market structure initiatives that I will touch on today is a broad one – steps to address concerns about fairness and efficiency in today’s high‑speed, algorithmic markets.

In the first instance, we should be fully cognizant of the many different ways that algorithms and speed are used by market participants, including investors, and the consequences of the varying proposals intended to curb them, including blunt tools like market-wide fees or time limits. As I emphasized in June 2014, the Commission should not attempt to roll back the technology clock or prohibit algorithmic trading. Algorithmic trading is not a monolithic phenomenon, and interventions must be targeted to the specific market quality issues presented. A fundamental tenet of this kind of calibrated regulation is to remain receptive to market-based solutions, and I continue to welcome competitive initiatives designed to benefit investors by de‑emphasizing the advantages of speed where appropriate.[21]

The Commission’s program to enhance operational integrity must also continue to focus on improving the monitoring and control of algorithms. The Commission’s market access rule has been a significant enhancement,[22] and we recently approved a FINRA initiative to qualify and register associated persons who design, develop, or modify algorithmic trading strategies.[23] And the Commission staff, at my direction, is developing a rule proposal designed to enhance recordkeeping and related requirements with respect to trading algorithms, while at the same time protecting the confidentiality of sensitive proprietary trading information.

Finally, and what I would like to briefly elaborate on today, the Commission should identify and address those specific elements of the algorithmic trading environment that may be working against investors, rather than for them.

EMSAC Recommendation for Maker-Taker Pilot

One such element that is widely discussed is the “maker-taker” fee structure used by the highest volume exchanges to charge access fees to brokers for orders seeking to access the exchanges’ liquidity, then rebating most of those fees to the brokers for orders that provide resting liquidity. When these fees and rebates are not passed through to customers, they raise concerns about, among other things, conflicts of interest between brokers and their customers, as well as the incentives they may provide high-speed traders.

As you know, in July of this year, the EMSAC recommended that the Commission test changes in the maker‑taker model by implementing a pilot program that would establish a series of lower caps on access fees than are currently in place. The EMSAC devoted a great deal of effort to developing this recommendation, and I have asked the SEC staff to follow up with a recommendation for the Commission to consider in the very near term.

Additional Initiatives Relating to Algorithmic Trading

In June 2014, I highlighted two additional initiatives relating to high-frequency trading. One is to clarify the status of unregistered active proprietary traders. The second is to address disruptive trading practices that could exacerbate price volatility in vulnerable market conditions.

One of the challenges in developing these initiatives has been to obtain and analyze all of the data that is needed to fully understand the parameters of algorithmic trading and to fashion the optimal regulatory responses. The public data feeds included in the Commission’s MIDAS system, for example, are helpful for understanding trading trends, but do not identify the nature of the market participants involved – including which orders and trades come from high-frequency traders.

The SEC staff has sought to capitalize on the regulatory data that is currently available, obtaining and analyzing data from the exchanges and FINRA that includes the identity of market participants. The usefulness of this type of data analysis is demonstrated by the joint staff report on the Treasury market volatility of October 2014.[24] That report found that only ten principal trading firms, many of which employ high-frequency trading strategies, represented approximately 50% of volume on the trading platforms for cash 10‑year Treasuries, a market that trades quite similarly to the equity markets. Most of this volume, however, occurs in entities that are not registered as government securities dealers and that therefore are not subject to regulation as broker-dealers.

While similar data on the equity markets shows that most, but not all, high-volume principal trading firms are registered with the Commission as dealers, further certainty about the registration requirements is imperative as business models and market practices continue to evolve. The Commission has therefore issued a proposal, which I expect will be finalized in the near future, to ensure that all registered dealers are subject to FINRA oversight as well.[25] The next step will be to give better clarity about the long-standing “dealer/trader” distinction.

The Treasury market report is also instructive in assessing trading practices that can potentially work against the interests of investors and issuers. It observed that two types of short-term professional traders – principal trading firms and bank-dealers – accounted for nearly the entire imbalance in aggressive buy orders that led to a sudden spike in prices. The surge in aggressive demand by these professional traders appears to have increased, rather than reduced, their exposure to the market in the direction of the price moves. Such trading is troubling because it suggests a destabilizing short-term trading strategy during a period of market weakness.

The Commission staff has been conducting similar analyses of regulatory data on the equity markets to assess the nature of trading during volatile periods. And there are concerns about similar trading behavior among some high-frequency trading firms, raising similar stability concerns.

One of the most difficult tasks in developing the right regulatory response to such potentially disruptive trading strategies is the need to avoid undue interference with practices that benefit investors and market efficiency.[26] Clearly, this is an issue that warrants full opportunity for a well-informed, data-driven public dialogue. To optimize our response, before the Commission settles on a proposal for an anti-disruptive trading rule, I have asked the SEC staff to assemble their work on disruptive trading practices for publication in the near future for the public to consider and comment on.

A Word on Quality Markets for Smaller Companies

Before closing, I would be remiss if I did not mention another guiding principle of market structure – one size does not fit all. So far, I have been talking about how the Commission intervenes in market structure to constrain practices that can be harmful for investors and issuers. But building a quality market for smaller companies is a different beast – it requires innovating new business models and practices, and there the private sector must largely lead the charge.

For the Commission’s part, it is important to continue to do whatever we can to support that innovation. I am pleased that trading in the pilot program to test the effect of wider tick sizes is set to begin next month, and I will be very interested in the results.[27] An enormous amount of work has gone into bringing this program to fruition – including by many of you. I agree with many observers, however, that a change in tick size, even if it were to prove highly beneficial, is not likely to fully address the needs of smaller companies and their investors. In short, our work here is not complete, even after implementing all of the rules required by the JOBS Act and creating new paths to capital for small issuers through Regulation A+ and crowdfunding.[28]

Conclusion

Each of the initiatives I have described today will make our markets stronger, better able to deliver real benefits for the investors and issuers they serve over the coming years. But, as I remarked earlier, working on market structure means never saying “good enough” – the job is unceasing.

The ultimate success of our market structure depends on the continued engagement of investors, issuers, the securities industry, and the wider public, as well as on the hard work of our fellow regulators. This engagement is central to our efforts today, as it will be for future Commissions.

The ambitious program of the last few years has drawn considerably from this ongoing dialogue. Our program is yielding positive immediate changes and – even more importantly – it provides a dynamic framework for continuing the comprehensive review of market structure that is essential to ensuring the U.S. capital markets remain the strongest and most reliable in the world.

[5] Compliance with the industry- or sector-wide coordinated testing provisions is not required until November of this year. In addition, ATSs meeting the volume thresholds in the definition of “SCI ATS” for the first time are allowed an additional six months from the time that the ATS first meets the applicable thresholds to comply with the requirements of Regulation SCI.

[10] The changes provide that following a trading pause triggered by limit-up/limit-down, the exchanges will either wait for the SIP to disseminate the new price bands or calculate the new price bands themselves before commencing trading. FINRA has also amended its rules to require its member trading centers to do the same. Securities Exchange Release Nos. 78435 (Jul. 28, 2016), 81 FR 51,239 (Aug. 3, 2016) and 78660 (Aug. 24, 2016), and 81 FR 59,676 (Aug. 30, 2016).

[13] The consolidation process required for the SIP means that information reaches users later than direct data feeds provided by exchanges, although the SROs have worked to reduce the latency. To help market participants assess the significance of the latency given their particular needs, I asked the exchanges and FINRA to consider including a timestamp in the SIP data on a real-time, quote‑by‑quote, and trade-by-trade basis. This timestamp was added last year, and clock synchronization was improved to help assure its usefulness. The UTP Plan implemented this change on July 27, 2015, and the CTA Plan implemented this change on August 3, 2015. Academics and commentators already have begun using the information to analyze SIP latency, and this transparency should enhance the ability of the public to assess the extent to which SIP data meets their needs. To do so, investors now also have more information about how equity exchanges use data feeds, such as in matching and routing orders, which were added in response to my request in 2014. BATS Rule 11.26; BYX Rule 11.26; CHX Rule 4; EDGA Rule 13.4; EDGX Rule 13.4; NYSE Rule 19.01; NYSE Arca Rule 7.37.01; NYSE MKT Rule 19.01; Nasdaq Rule 4759; PHLX Rule 3304; BX Rule 4759; and NSX Rule 11.25.

[21] The most prominent example to date of such an initiative has been the Commission’s approval of IEX’s application to be a national securities exchange with a protected quote. See Securities Exchange Act Release No. 78101 (Jun. 17, 2016), 81 FR 41,142 (Jun. 23, 2016). IEX incorporates a 350 microsecond delay in its trading system. The purpose of this “speed bump” is to enable IEX to update the pricing of its pegged-price orders before they can be executed at stale prices by fast traders. IEX began operating as an exchange as of September 2, 2016, and intends to be fully trading with a protected quote no later than September 15, 2016. The Commission has directed the staff to conduct a study regarding the effects of intentional access delays on market quality, including price discovery and report back to the Commission with the results of any recommendations.

[26] For example, ETPs rely on firms that are able to quickly and efficiently find and trade on the arbitrages between the ETP product and its associated benchmark. As last August 24 demonstrated, preventing this arbitrage from functioning effectively would disrupt the functioning of many ETPs that investors in those products have come to rely on each day.